Deal Struck Between Kemper, Berkshire

The Kemper Insurance Companies last week entered into a“comprehensive strategic relationship” with Berkshire Hathaway,involving investment and reinsurance transactions, the Long Grove,Ill.-based insurance group announced.

According to Kemper, Omaha, Neb.-based Berkshire will make a$125 million equity investment in Kempers commercial insuranceoperations through a newly-formed stock subsidiary. In addition,Berkshire will participate in several reinsurance agreements withKemper.

Kemper President and Chief Operating Officer William D. Smithexplained the deals, noting that the first step was for KempersLumbermens Mutual Casualty Company to create a downstream stockholding company called Kemper Insurance Group Inc. That company, inturn, owns a downstream insurance company licensed only to doreinsurance in Illinois. Lumbermens contributed $700 million incapital to the holding company, representing an 85 percent share.Berkshire's $125 million represents the other 15 percent.

Mr. Smith said 100 percent of the balance sheet of the“go-forward commercial business” of Kemper is going to be cededfrom Lumbermens to the new insurer, in a transaction that issubject to regulatory approval. “Thats essentially everything” on ago-forward basis, he said, noting that Kemper sold its personallines renewal rights to Unitrin in Chicago last month for some $45million.

He said that the cession of the balance sheet is one aspect thatmade the deal more attractive to investors than putting money intooffshore start-ups, noting that the reserves will generateinvestment income. A representative of Berkshire Hathaway referredall questions to Kemper.

Mr. Smith said Lumbermens will also cede 80 percent of thepremiums of its go-forward commercial business. Lumbermens retainsall the employees and licenses and appoints all the agents.

Turning to the reinsurance agreements between Berkshire andLumbermens, he said there are three. One is a two-year quota-shareceding $535 million of the net premiums of the new reinsurer toBerkshire. Mr. Smith said Kemper expects to write roughly $2billion, with Lumbermens retaining 20 percent and the new companyretaining about $1.2 billion (80 percent minus the $535million).

The quota share with Berkshire was done to get the net writtenpremium down to a level supported by the surplus of the KemperCompanies, he said, noting that surplus fell roughly $550 millionat year-end 2001. The decline related in large part to asbestosreserving issues, he said, noting that Berkshire also provided somereinsurance coverage to asbestos.

Karen Horvath, a vice president for A.M. Best in Oldwick, N.J.,said the 27.8 percent surplus drop, which followed a 24.5 percentdrop a year earlier, also related to changes in accounting rulesaffecting how Kemper could account for some of its subsidiaries.She said the drop in surplus was what had concerned A.M. Bestbefore the transaction.

Even considering the transaction, Best downgraded Kemper to“A-minus” from “A” last week, citing limitations on financialflexibility and the ongoing costs of reinsurance, among otherthings.

Mr. Smith and Ms. Horvath also described a second treaty withBerkshire as a $400 million adverse development cover on year-end2001 non-asbestos and mass tort reserves of $3.5 billion. Mr. Smithsaid that the coverage plays to the interests of other investorsthat have expressed interest in investing in a new company. “Lesssophisticated investors will worry about reserves,” he said.

“I think there could be other investors,” he said, noting that anumber were and are still interested. Berkshire has an automaticright, at a set price, to modestly increase its participation and aright of first refusal on additional investments.

Mr. Smith said that after Sept. 11, an investment bank came inwith the idea of investing in Kemper, which at the time was not apossibility because Kemper is a mutual insurer. The banker, hereports, noted that Kemper, unlike some offshore start-ups, alreadyhad the talent and distribution in place to take advantage of themarket.

To allow for investments, Kemper would have to create a legalentity for others to invest in and completely reserve for asbestos,he said. Although Mr. Smith reports that Kemper was working withfive or six other investors, he noted that Berkshire stepped in andsaid they could quickly do all that was required.

Mr. Smith, who in the past told National Underwriterthat being a mutual was a distinguishing feature of Kemper, saidthat demutualization could now be in the insurers future. Mutualityserved the company well over the past couple of years, he said. “Ifwe hadnt been a mutual, we couldnt have done what we did,” headded, referring to five years of restructuring and bringing inintellectual capital. “Shareholders wouldnt have put up withthat.”

But with all those actions completed, “theres a real issuearound whether we can generate sufficient capital to supportgrowth, especially if the current rate environment continues,” hesaid, noting the board has met several times to discuss whether itis appropriate to remain a mutual. “Thats an open questionnow.”

Mr. Smith described a final treaty as a catastrophic risk runofftreaty on personal lines business. “We didnt want to do all thisfinancial engineering and restructuring and have a big windstormclaim hit the homeowners book this summer, while its running off,”he said.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, May 13, 2002.Copyright 2002 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.